How much risk should we build into the asset allocation for our clients? That question is difficult to answer.
But Daniel Kahneman, who won the 2002 Nobel Memorial Prize in Economic Sciences, and Amos Tversky developed prospect theory in the field of behavioral economics, and this might offer some help.
Prospect theory, in very simple terms, shows that most human beings get more pain from losing a dollar than pleasure from gaining a dollar. For example, many people will turn down a coin flip where heads will win $150 and tails will lose $100. Turning down a wager that has a $25 expected gain is irrational.
Investment data demonstrates that investor returns lag behind fund returns. This is because investors are greedy when an asset surges and fearful when it plunges. Rebalancing requires just the opposite dynamic, where the investor must buy an asset class when the herd is fearful and sell when the herd loves it.
Applying prospect theory would indicate that investors are more likely to react to the pain of a plunge than to the greed of buying after an asset class has surged.
So, for example, if you and a client determine that risky assets should make up 50% to 60% of the portfolio, perhaps 50% is the better answer. This way, if stocks tank, the client can be glad he didn’t pick the higher allocation and the rebalancing will be buying more stocks at a discounted price. He may not be happy if stocks surge, but he can still feel pretty good as the statement balance increases.
In addition to prospect theory, most people are more risk tolerant when stocks are near an all-time high (now) than after a plunge. This also argues for setting a conservative allocation to reduce regret whenever the next bear market shows up.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.